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Why Earnings Look Opaque Beyond Third Quarter


In this recovery, historical analogies may not apply.

This week marks the start of the third-quarter-earnings season, as Alcoa (AA) reports earnings on October 7.

The Street is expecting corporate earnings to decline 24.8%, which would mark the first time the S&P 500 has recorded nine straight quarters of negative growth since Thomson Reuters began tracking the data in 1998.

However, that 24.8% drop is still slightly better than the 27.3% fall in the second quarter. In fact, analysts say earnings should show signs of improvement over for the short term, due to cost control, inventory restocking, and easy comparisons against a terrible 2008 -- particularly among the financials.

"Things get less bad this quarter, with smaller year-over-year losses than in the first quarter and second quarter," S&P equity analyst Alec Young tells us.

Looking further ahead, for 2010, the crystal ball of professional forecasters becomes much cloudier and, frankly, your guess is as good as that of any bow-tied CFA working on Wall Street: Nobody really knows how this struggling economy will perform once it's weaned off Uncle Sam's massive federal subsidies.

Last Friday, as the lousy employment report emphasized in gruesome detail, this US economy continues to really suffer. The report was awful. As David Rosenberg of Gluskin Sheff notes, there can be no durable recovery without net job creation and organic wage growth, which were both lacking in the jobs survey.

So, can earnings recover even if employment remains this weak?

Ed Yardeni of Yardeni Research thinks they can. "US companies are scrambling to decouple from the US economy, and are finding more revenues and earnings overseas, especially among emerging economies," the investment strategist writes in a client note.

"Furthermore, even a subpar recovery in domestic revenues could morph into significant earnings growth given all the cost cutting that has been going on during the recession," Yardeni argues.

Charles Rotblut, senior market analyst for, agrees that, at least short term, earnings prospects look better for the market.

He's telling his subscribers to hold less economically sensitive sectors like health care, which he likes, in part, because it's cheap.

He plays the sector by holding the Health Care Select SPDR (XLV), an ETF with holdings including Abbott Laboratories (ABT), Gilead Sciences (GILD), Medtronic (MDT), and Pfizer (PFE).

Rotblut balances out the portfolio by also committing capital to a more aggressive growth sector like technology. Analysts expect technology companies to show a combined 15% decline in third-quarter profits, but then climb 22% in the fourth quarter.

Rotblut holds the iShares S&P North American Technology-Semiconductors Index Fund (IGW), an ETF with holdings including Applied Materials (AMAT), Intel (INTC), NVIDIA (NVDA), and Texas Instruments (TXN).

He also likes the iShares S&P North American Technology Sector Index (IGM), an ETF with holdings such as Apple (AAPL), Cisco (CSCO), and Google (GOOG).

What about that fumbling financial sector? It's expected to be the best performer this quarter, with earnings on average forecast to climb 59% from the year-ago period.

Rotblut counsels caution, urging stock pickers to target-shoot for opportunity.

"Part of that huge growth is because the first quarter and the second quarter were such disasters this year so that makes the numbers look good in comparison," he says. "Now, there are companies that seem like they're doing well, like Goldman Sachs (GS). On the flip side, companies like Citigroup (C) and Zions Bancorp (ZION) still have a lot of exposure to those areas hit hardest by the real estate market."

More broadly, as third-quarter earnings season kicks off, the Street wants to see some improvement now in lackluster corporate revenue, says Peter Boockvar, Miller Tabak's equity strategist.

Last quarter, companies beat lowball estimates on cost-cutting and layoffs, but investors are going to want to see some top-line growth.

"Unlike the second quarter, where people rewarded better-than-expected EPS numbers and shrugged off revenue misses, there will be more of a focus on whether companies are driving revenue in a difficult economic environment," Boockvar tells Minyanville.

He adds, "If the company is US-centric, whether it's a retailer or a bank, then revenue growth will be tougher to come by. If you have exposure to overseas markets, particularly those that had pretty healthy GDP growth in the second quarter and the third quarter, such as Asia, then you will be much better off."

For all of 2009, earnings are expected to fall 16.9% from 2008's level. However, in 2010, analysts see profits rising 26.5%. Investors obviously agree with this peachy scenario, evidenced by an explosive seven-month rally that has taken the S&P 500 up nearly 60% from the March 9 lows.

According to Thomson Reuters, number crunchers predict profits generated by materials companies rising 85% in 2010; 73% for financials; 47% for energy companies; 37% for consumer discretionary companies.

Our response: Who cares?

This is pure guesswork. None of us knows how the US economy will perform next year. Right now, it's impossible to even get a real, honest reading on this ailing economy of ours, seeing as how the patient is currently all hopped up on medicine from the federal government, like Cash for Clunkers and housing subsidies.

What we've witnessed is a degree of government intervention in the economy that would make a bearded Che Guevara blink. Now we all wait and see, fists clenched, as to what happens when the government stimulus wears off.

Given that uncertainty, the proper response by investors to 2010 projections is skepticism. Your forecast is just as good as that pencil-necked Wharton graduate now spinning spreadsheets at Deutsche Bank.

"In an uncertain environment like this, trying to glean 2010 estimates is foolhardy," says Boockvar. "Nobody knows how the economy will turn out next year. A lot of people still think this will be a typical post-WW II recovery. But the downturn wasn't typical and the upturn won't be either. The historical analogies and benchmarks won't necessarily apply this time."

So where would Boockvar be putting money to work? Right now, he likes hard assets: commodities, commodity producers, countries that produce commodities, and anything ex-US, particularly Asia.

"My bottom line is you have to protect yourself from this depreciation of the dollar, which is the unofficial government policy," he says.

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